by Rick Ferri
What happens in Washington has broad-reaching effects on the economy and our personal wealth. Uncertainty over economic policy is often thought to be a bad omen for future stock prices while general agreement is thought to be good for stocks. New evidence shows the current level of economic policy uncertainty is reflected in stock prices; although, it isn’t useful in predicting the market.
Measuring economic policy uncertainty is an area of interest for economists. A new gauge, the Economic Policy Uncertainty Index, was introduced in 2013 by Scott Ross Baker (a fifth-year Ph.D. candidate in the Stanford Department of Economics), Nick Bloom (Professor of Economics at Stanford University), and Steven J. Davis (Deputy Dean of the Faculty and William H. Abbott Professor of International Business and Economics at the University of Chicago Booth School of Business).
The trio wrote a paper, titled Measuring Economic Policy Uncertainty, in May 2013 that combined several variables to arrive at their index. The underlying components include newspaper coverage of policy-related economic uncertainty, the number and projected revenue effects of federal tax code provisions set to expire in future years, and disagreement among economic forecasters about policy-relevant variables as a proxy for economic policy uncertainty.
In formulating the U.S. index, the authors identify articles from 10 leading newspapers that contained the words ‘uncertainty’ or ‘uncertain’, ‘economic’ or ‘economy’, and one or more of the following terms: ‘congress’, ‘deficit’, ‘federal reserve’, ‘legislation’, ‘regulation’ or ‘white house’ (including related terms like ‘regulatory’ or ‘the fed’). The article had to include terms in all three categories pertaining to uncertainty, the economy, and policy to be included in the index.
The index also draws on Congressional Budget Office (CBO) sources that list federal tax code provisions set to expire in coming years and their projected revenue effects. Scheduled tax code expirations are a source of uncertainty because Congress often waits till the last hour before deciding what to do about them, undermining stability in and certainty about the future path of taxes.
Last, the index draws on the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters (SPF). Each quarter, SPF participants receive a request to provide forecast values for a range of variables at various horizons. Here, the authors utilize the dispersion between individual forecasters’ predictions about future levels of the Consumer Price Index, Federal Expenditures, and State and Local Expenditures to construct indices of uncertainty about policy-related macroeconomic variables.
Uncertainty indexes are calculated regularly for five major economic regions (U.S., Europe, Canada, China and India). Data can be downloaded for all regions from www.policyuncertainty.com. Some indices data is published daily and others are published monthly. Figure 1 highlights the monthly U.S. uncertainty index level.
Figure 1: Monthly U.S. Economic Policy Uncertainty Index (Jan. 1985 – Mar. 2014)
Source: Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com
The authors created a separate U.S. Equity Market-related Economic Uncertainty Index, and the daily data is available for download on their website. This is a count of news articles containing terms from three categories relating to uncertainty, the economy and the stock market. According to the authors, the newspapers range from large national papers like USA Today to small local newspapers across the country.
Figure 2 illustrates the 92-day moving average for this daily data. I used 92 days because it roughly corresponds to one calendar quarter.
Figure 2: 92-day moving average (log) of the U.S. Equity Market-related Economic Uncertainty Index
Source: Chart by Rick Ferri. Data from Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com
The Equity Market-related Economic Uncertainty Index is currently near a low point. This indicates that newspapers are publishing relatively few articles focusing on uncertainty and the stock market. The index correlates relatively close with changes in stock prices. Price shocks generate more fear and more articles about policy-related events and stock prices in the press.
Baker, Bloom and Davis compared the returns of the S&P 500 to their indexes to see if inferences could be drawn. The authors note that the number of large movements in the S&P 500 index, defined as a daily change of 2.5% or more, has increased dramatically in recent years relative to the average since 1980. In addition, a larger share of the movement was caused by policy-related events. Figure 3 illustrates this phenomenon.
Figure 3: Large stock movements caused by policy-related events (1980-2011)
Source: Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com.
The data leads to questions about predictability. Does the current level of uncertainty predict future prices? Do changes in the level of uncertainty predict future volatility?
To answer this question, we turn to a recent article, titled Economic Policy Uncertainty and the Stock Market, published by CXO Advisory Group. The article compares the monthly behaviors of the S&P 500 Index and the Economic Policy Uncertainty Index (EPU) over the available sample period.
Figure 4 summarizes correlations between monthly S&P 500 Index return and monthly percentage change in the EPU Index for various lead-lag relationships. The time period ranges from stock market return leads change in EPU Index by 12 months (-12) to change in EPU Index leads stock market return by 12 months (12).
Figure 4: The lead-lag relationship between economic policy uncertainty and stock prices
Source: CXO Advisory with permission.
There appear to be little correlation between the past or future returns of the S&P 500 and the Economic Policy Uncertainty Index. The strongest indication CXO found is that the two series are coincident and cannot be exploited for financial gain using a trading strategy. Other lead-lag relationships appear to be noise. The article concludes: evidence from several tests offers little support for the belief that the EPU Index is useful for U.S. stock market timing.
What happens in Washington has far-reaching effects on the economy. Although uncertainty over policy is reflective in current stock market prices, attempting to use this data to forecast stock prices is another matter. There is little evidence that the current level of government policy uncertainty or changes in this level can be used to accurately time the stock market.
Copyright © Rick Ferri
